Individual small-cap stocks can oftentimes outperform their large-cap counterparts because small-cap companies tend to be able to grow faster while receiving less analyst coverage.
This article covers when small-cap stocks tend to perform well, why they can be good investments, and what investors should consider before adding them to a portfolio.
Table of Contents:
- Why Individual Small-Caps Outperform
- The Small-Cap vs. Large-Cap Valuation Gap
- Market Cycles and Small-Cap Performance
- Small-Cap Risks
- Are Small-Caps Right for Your Portfolio?
Let’s dive in!
Why Individual Small-Caps Outperform
Higher Growth Potential Due to a Smaller Revenue Base
Large companies struggle to grow as quickly as small companies because they already dominate their industries.
Small-cap stocks, on the other hand, start with lower revenue, which makes it easier for them to double or triple sales in a short time.
For example, The Trade Desk (TTD) had under $100 million in annual revenue when it went public in 2016.
As digital advertising spending soared, the company expanded rapidly, pushing its stock price up more than 40x.
Less Analyst Coverage Creates Market Inefficiencies
Wall Street analysts focus more on large-cap stocks, which leaves many small-cap companies underfollowed. This lack of coverage creates opportunities for investors who do deep research.
Example: In the early 2000s, Trex (TREX) dominated the composite decking market but received little analyst attention.
As demand for low-maintenance decking surged, Trex grew into a multi-billion-dollar company, which was very rewarding for its early investors.
More Room for Innovation and Market Disruption
Small-cap companies often operate in emerging industries or create disruptive products.
They move faster than larger competitors, allowing them to capture market share before established businesses react.
For instance, Upstart (UPST) used artificial intelligence to improve credit underwriting.
The company’s ability to innovate quickly helped it grow revenue rapidly, though macroeconomic challenges later impacted its stock price.
Increased Acquisition Potential by Larger Firms
Large companies frequently buy small-cap stocks to expand their product offerings or enter new markets. Investors who buy small-caps with strong acquisition appeal can benefit when a larger company offers to acquire the smaller company at a premium price for the stock.
For example, Salesforce (CRM) acquired Slack (previously $WORK) in 2021 for $27.7 billion, at a premium price to what Slack stock was trading at before the acquisition.
Slack had positioned itself as a key player in workplace communication, and its acquisition premium rewarded shareholders who recognized its long-term potential.
The Small-Cap vs. Large-Cap Valuation Gap
Small-Caps Trade at Lower Valuations
Small-cap stocks often trade at lower earnings and revenue multiples than large-cap stocks for several reasons:
- Higher perceived risk: Investors pay less for smaller companies with less stable earnings.
- Less institutional ownership: Large funds allocate most of their capital to blue-chip stocks, so these stocks have more demand.
- Limited financial transparency: Small companies generally provide less data for investors, so these companies tend to have less investor confidence.
How Institutional Ownership Impacts Valuation
Many small-cap stocks have low institutional ownership, leading to less buying pressure. As companies grow and attract large investors, their stock prices often rise.
For instance, Cloudflare (NET) had low institutional ownership early on. As hedge funds and mutual funds recognized its growth potential, more capital flowed into the company, which pushed the stock higher.
By understanding the valuation gap between small-caps and large-caps, investors can identify stocks with room to re-rate at a higher multiple as they grow.
Market Cycles and Small-Cap Performance
Small-cap stocks go through cycles of outperformance and underperformance. Investors who recognize these patterns can adjust their strategies to maximize returns.
When Small-Caps Tend to Outperform
Small-cap stocks perform well in certain market conditions, including:
- Bull markets: Investors take more risks, driving demand for small-cap stocks.
- Economic expansions: Small businesses benefit from rising consumer and business spending.
- Falling interest rates: Lower borrowing costs help small companies invest in growth.
Example: From 2009 to 2013, the Russell 2000 Index outperformed the S&P 500 as the economy recovered from the financial crisis.
Lower interest rates and improving corporate earnings fueled small-cap gains.
Additional Example: After the Fed cut rates in 2020, small-caps had a historic rally, with the Russell 2000 surging over 100% from its pandemic low.
When Small-Caps Struggle
Small-caps are less likely to outperform during tough market conditions:
- Recessions: Economic slowdowns hit small businesses harder than large corporations.
- High inflation: Rising costs can squeeze small companies with lower pricing power.
- Rising interest rates: Higher borrowing costs impact small businesses more than cash-rich large firms.
For example, in 2022, as the Federal Reserve raised interest rates aggressively, small-cap stocks lagged large-caps. Investors rotated into more stable, cash-flow-generating businesses, leaving riskier small stocks behind.
Small-Cap Risks
While small-cap stocks can deliver strong returns, they also come with additional risks that investors must consider.
Liquidity Risks and High Volatility
Small-cap stocks often have low trading volume, leading to:
- Larger price swings: A single large trade can move the stock significantly.
- Wider bid-ask spreads: Investors may pay more when buying and receive less when selling.
For example, micro-cap biotech stocks often experience extreme volatility, rising or falling 50%+ in a single trading session based on news or earnings reports.
Macroeconomic Sensitivity
Small businesses tend to be more vulnerable to economic downturns than large corporations. Investors should watch for:
- Debt burdens: Small firms with high leverage may struggle in slowdowns.
- Consumer demand shifts: Discretionary spending declines hit small retailers and service providers first.
For example, during the 2008 financial crisis, many small banks and retailers collapsed, while large corporations with diversified revenue streams weathered the storm better.
Dependence on a Few Key Customers or Suppliers
Many small-cap stocks rely on a single customer or supplier for a large portion of revenue.
Losing that relationship can cause serious financial trouble.
For example, GoPro (GPRO) depended heavily on Best Buy (BBY) and Amazon (AMZN) for distribution, making it vulnerable to shifts in retail demand.
As sales growth slowed and competition increased, the company struggled to diversify revenue, contributing to a steep stock decline.
Are Small-Cap Stocks Right for Your Portfolio?
Historically, small caps have outperformed large caps over long periods.
But, small-caps also carry higher risks. Their volatility, lower liquidity, and sensitivity to macroeconomic trends mean investors need a strategy that accounts for both upside potential and downside protection.
Ultimately, every investor’s situation is different, from risk tolerance to time horizon and financial goals. It’s up to each person to choose investments that fit their strategy.
How Small-Cap Stocks Fit into a Diversified Portfolio
Investors should consider small-caps alongside other asset classes to balance risk and return. Small-cap exposure works well when combined with:
- Large-cap blue-chip stocks: Provides stability and dividend income.
- Mid-cap stocks: Bridges the gap between fast growth and established businesses.
- International stocks: Expands opportunity beyond U.S. markets.
For example, an investor who held both small-cap growth stocks and dividend-paying large-caps in the 2010s saw strong returns with lower volatility than an all-small-cap portfolio.
The Importance of Long-Term Thinking
Small-cap investing rewards patience. Many of the best small-cap stocks take years to realize their full potential.
Investors who focus on long-term trends, strong fundamentals, and proven management teams often achieve better results than those trying to trade short-term price swings.
For instance, MercadoLibre (MELI) spent years expanding in Latin America before becoming an e-commerce giant. Investors who stayed patient instead of selling on early volatility saw exponential gains.
By understanding when small-caps perform best, managing risk effectively, and thinking long-term, investors can use small-cap stocks to enhance portfolio returns while minimizing downside exposure.
Frequently Asked Questions (FAQs)
1. Why do small-cap stocks tend to outperform large-cap stocks?
Small-cap stocks tend to outperform large-cap stocks because they have higher growth potential, face less analyst coverage, and often operate in underpenetrated markets. These factors create opportunities for investors to find undervalued companies before they gain widespread attention.
2. When do small-cap stocks underperform?
Small-cap stocks underperform during recessions, periods of high inflation, and when interest rates rise, making borrowing more expensive. In these environments, investors often shift capital toward large-cap stocks with stronger balance sheets.
3. Are small-cap stocks riskier than large-cap stocks?
Small-cap stocks carry more risk than large-cap stocks due to lower liquidity, higher volatility, and greater sensitivity to economic conditions. However, investors who manage risk well can still achieve strong long-term returns.
4. How do interest rates affect small-cap stocks?
Interest rates affect small-cap stocks because rising rates increase borrowing costs and reduce liquidity in the market, making investors more risk-averse. Conversely, falling rates often boost small-cap performance by improving access to capital and encouraging economic growth.
5. What is the best time to buy small-cap stocks?
The best time to buy small-cap stocks is early in an economic recovery, after a major market sell-off, or when interest rates peak and start to decline. These conditions often create attractive valuations and strong growth opportunities for small-cap companies.
TIKR Takeaway
Small-cap stocks can offer some of the highest potential returns in the market.
The TIKR Terminal offers industry-leading financial data on over 100,000 stocks, so if you’re looking to find the best stocks to buy for your portfolio, you’ll want to use TIKR!
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Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold any positions in the stocks mentioned in this article. Thank you for reading, and happy investing!
